A Recovery Plan Which Would Actually Work (and which isn't designed by the ex-chairman and CEO of Goldman Sachs for his buddies)

I have watched with a combination of amazement and horror at the way the Democratic leadership has caved in to demands that Congress enact the Paulson Plan. There are many reasons for opposing this ill-conceived plan, including the facts that it aims only at rescuing the shareholders and unsecured creditors of financial institutions and it was crafted by a former chairman of Goldman Sachs to bail his banker buddies out while leaving the rest of us with a bill for as much as $700 billion. But the worst of it is that it will do very little to address the fundamental credit contraction arising from deflation of a massive housing bubble which underlies the current crisis, as evidenced by the continued worsening of money markets even after the Senate’s adoption of the revised plan.

I have nearly laughed myself silly at Republican claims that the Paulson Plan amounts to socialism (in fact, it’s far closer to the Mefo Bill scheme that Hjalmar Schacht designed than anything the left would come up with). So I offer a plan designed by a left social democrat that would actually address the economic basis of the current credit crisis (and, thus, a socialist way to really pull capitalism’s chestnuts out of the fire). The plan is heavily influenced by Nouriel Roubini’s excellent analysis — I heartily recommend his blog for extremely insightful discussion of the credit crisis — but goes much further in remedying the underlying flaws in the financial system.

More below….

The first step is to federally license all financial institutions. We license doctors; we license lawyers; hell, we license tattoo artists. We should license all persons and entities who engage in the provision of financial services. And if you don’t want to opt into the recovery plan, then you can shutter your institution, because you don’t get a license. Now follows the plan:

• Immediately reestablish New Deal-era regulation of financial institutions: we don’t need to get hit on the head with a hammer dozens of times to realize that deregulation has done nothing but hand the financial henhouse over to the foxes. Markets operate on the principle of greed (it’s what profit maximization means), and greed without strict oversight to ensure the public interest ensures catastrophic business cycles.

• To deal with the immediate effects of collapsed assets on capital illiquidity order a mandatory exchange of illiquid assets for government preferred ownership of preferred shares in financial institutions senior to existing preferred and common shares currently held by stockholders (to ensure that the government is first to recoup the outlay on economic recovery).

• Since there will still be a need for undercapitalized financial institutions to increase their capitalization to compensate for losses from writing down assets being sold to the government, have the government provide additional capital by purchasing further preferred shares in those institutions, as the RFC did in the New Deal.

• As a condition of receiving these recapitalizations by public funds, financial institutions must include a percentage of government representation on their boards of directors at least equivalent to the percentage of total assets these recapitalizations represent. Such government-appointed board members will have responsibility to oversee financial institution operations and report practices which threaten financial stability to the relevant regulatory agencies and the Department of Justice.

• To reduce the risk to the government arising from this infusion of public capital financial institutions need to take a first-tier loss by suspending dividend payments on preferred and common shares and forcing shareholders to match the public investment.

• To prevent unsecured creditors from unfairly benefiting from the recapitalization, mandate partial unsecured debt for equity swaps at a reasonable percentage rate.

• Since many of the financial institutions which will benefit from these measures have systematically avoided federal taxation by creation of offshore asset-protection schemes, all financial institutions should be required to fully repatriate all funds from such schemes within two years and pay all appropriate back taxes on these funds.

• Create a federal agency to evaluate the solvency of financial institutions and conduct triage of institutions which can be recapitalized to recovery and those which should be allowed to go bankrupt and be closed.

• Recreate the Home Owners’ Loan Corporation (HOLC) to buy mortgages at a discount rate from financial institutions, reduce the face value of the mortgages, and refinance the mortgages at rates which keep the homeowner in the home. This should be done by HOLC, as it was in the New Deal, rather than by bankruptcy court judges, since forcing homeowners who were victims of unscrupulous lending practices into bankruptcy to receive relief is fundamentally unfair.

• Ban the practice of short-selling the stock of financial institutions.

• Immediately authorize up to $50 billion for the Department of Justice to investigate all aspects of violations of federal law by financial institutions and their employees and prosecute the malefactors to the full extent permitted by law.

• To fund these programs establish an immediate and permanent .50% tax on all stock transactions. This will have the additional salutory effect of reducing speculative churn in the market.

• Prohibit the outsourcing or privatization of any government function pursuant to these measures. Let regulation of the financial sector be conducted by public employees answerable to our elected representatives.

And then we spend the $700 billion on a single-payer national health care system and a jobs-creation program rebuilding our delapidated national infrastructure (and maybe building a free national broadband system that would rival the Japanese and the Koreans).

4 Comments

* There already is a law on the books in regards to short selling– Reg T. The problem is the post dating is after the transaction date. If the trader was required to put up the 150% of the trade in the beginning that would tamp down the speculative side of the short sale mania. Electronic trades make that a reality.

* You want to create a federal system of oversight on financial institutions when there was one — SEC — who failed in their function to begin with. Why placing govt employees on the board on one hand then having federal auditiors on the other hand you create a situation where ‘shoot, shovel and shut up’ will be the order of the day. Provide more teeth to the auditing function of accounting firms would bear a lot more fruit.

* Suspend dividend payments. All fine and dandy. But what are you going to tell Ma Frickert whose retirement income is J.P. Morgan stock? — ‘eat cat food bitch!’ I don’t think you will get very far.

* Unscrupulous lending. First of all if somebody is making $2500/mo and is presented with a closing statement of $1500/mo they should know they are in trouble already, with a possible ratchet up in 3 years. The whole scam was a two way street. Buyers falsifying income/assets as much as brokers offering financial instruments ill suited to the buyer. Enough blame to go around.

The final nail of your whole proposal is that it hides the ‘moral hazard’ factor of capitalism. So long as the firm thinks it can’t fail and the government is a willing accomplice in that fantasy then any risk is acceptable. That is the component that has to stop. One cannot gain success without the assured ability to fail. That fear is what keeps the capitalist from going too far.

In action. I say let it burn. Does it means dislocation? You bet. But it is the only way the system has to flush out the losers and reallocate assets to successful enterprises. You can drop and be back up in 5 years or you can follow the Japanese model and be in a funk for 2 decades.

You confuse me with someone who wants the whole rotten system back up in five years. I don’t propose to hide the “moral hazard” of capitalism — I propose to eliminate it by rational triage and then to install regulatory measures which make recurrent bubble crises hugely more difficult to create, i.e., that we go back to a policy of trying to systematically level the business cycle by government regulation. The notion that the market disciplines is a fallacy. We can have regulation keeping capitalists from going too far or we can have have the fear that people will rip them from their mansions and hang them from lamp posts keep them from going to far. I’d be happy to go either way, but the former creates less social disorder than the latter.

Two thoughts on your old note. I think you left out clawbacks – if one were to be terribly ironic, return that money to shareholders, or the government. At the same time, clawback fees, costs and payments to AWOL Board Members.

BUT: Not all home loans were corrupt. Some were fine, some were stupid, some were insanely stupid, some were fraudulent. In this case, I think your brush is too broad.

I say this as someone who paid too much (but what I could probably afford), who is not bankrupt or near it. I was, perhaps, foolish: I think I understood what I was doing, and the risk, and made choices that did not include taking any near-term profit on my new home.

Why should I, or someone like me, not bear the burden of my choices – when at the same time the tenor of your comments against the bank-masters is that they must bear the burdens of theirs?